Ares Capital Stock: Get that safe 9.2% yield with a marginal premium to book (NASDAQ:ARCC)
A recession has arrived, making it more important than ever for dividend investors to invest in business development companies that have a long track record of successfully managing investors’ money.
Ares Capital (NASDAQ: ARCC) is a highly regarded business development company with a long history of high yields on fairness. BDC also has a conservative asset allocation and strong net investment income, which allows it to cover its growing dividend payouts. Even when trading at a premium to NAV, ARCC is a buy.
Portfolio structure unchanged
Ares Capital’s investment portfolio did not change much in 2Q-22: the business development company had an uneventful quarter in terms of portfolio composition, with only minor changes in investment structure.
As of June 30, 2022, senior secured loans represented 45% of Ares Capital’s portfolio, while senior secured loans represented 19% of loan investments.
Second Liens’ weighting decreased by 2 percentage points from the prior quarter, while BDC’s investment allocation to investment manager Ivy Hill Asset Management increased by 2 percentage points. As of June 30, 2022, Ares Capital’s total investment value was $21.7 billion.
Ares Capital’s new investments made in the second quarter are more attractive than the company’s little-changed portfolio structure. Ares Capital made new commitments primarily in senior secured senior notes, with this category accounting for 71% of new investments.
After Ivy Hill Asset Management, Ares Capital holds equity and subordinated loan investments. Ares Capital’s largest investment, accounting for 8.5% of investments, is Ivy Hill Asset Management, which received 18% of new commitments.
Due to its size and equity nature, the investment has the potential to generate excess returns for Ares Capital. Ares Capital’s other investments, primarily Senior Loans, received the remaining 11% of new commitments.
Asset quality remained high
In 2Q-22, Ares Capital’s balance sheet quality remained solid. In 2Q-22, BDC’s total non-recognition ratio based on fair value was 0.9%, an increase of 0.3% quarter-on-quarter. The non-recognition ratio calculates the total dollar value of the loans, in this case $180 million, that are at risk because they were made to distressed borrowers. Ares Capital has an exceptional underwriting record and has historically had first lien loss rates of less than 0.1%.
I consider a non-recognition ratio below 1.0% to be quite strong, and despite a slight increase in non-recognitions in 2Q-22, Ares Capital’s ratio remained below this threshold.
LTM payout ratio is now 90%
Ares Capital had a strong 2Q-22 as the portfolio continued to perform well, as evidenced by the company’s net investment income. The second quarter NII rose 50% year-over-year to $257 million, driven by a broad recovery in asset values and an improving economic outlook post-Covid-19.
Ares Capital earned net investment income of $0.52 per share, for a 2Q-22 payout ratio of 81%. Ares Capital has only paid out 90% of its net investment income over the past twelve months, so the dividend was easily covered.
Management recently increased the dividend by $0.01 per share, or 2.4%, bringing the regular dividend to $0.43 per share. Ares Capital previously declared a special dividend of $0.03 per share, which will be paid in addition to the regular base dividend on September 30, 2022.
To receive the dividend, investors must buy before the ex-dividend date, which is September 14, 2022. ARCC stock is currently yielding an 8.9% yield based on the regular dividend only and assuming the dividend will be maintained at $0.43 per share. When two special dividends of $0.03 per share are added in September and December, the yield jumps to 9.2%.
Slight premium to net asset value
Ares Capital seems to me to be fairly valued, as the stock is trading close to NAV. Ares Capital’s net asset value per share at the end of the second quarter was $18.81. BDC’s net asset value decreased by $0.22 per share, or 1.2%, due to net unrealized losses in the portfolio.
Ares Capital has a P/NAV ratio of 1.03x, reflecting a premium of 3%, based on a new net asset value of $18.81. Ares Capital has historically traded at higher P/NAV ratios and higher NAV premiums, but I think it’s reasonable to pay around book value for BDC given the company’s track record in successful management of investors’ capital.
Why Ares Capital Could See Lower Stock Price and Valuation
As long as Ares Capital’s miss ratio remains as low as it currently is, there is no material credit quality issue in BDC’s loan portfolio to worry about.
It also means that the net asset value of the company and its ability to cover dividend payments with net investment income are not at risk. However, the situation changes if more borrowers experience stress and loan losses increase.
I buy BDC for the dividend because Ares Capital has a long track record of picking strong credit quality (low loan losses).
Ares Capital had a strong second quarter: the portfolio continued to perform well, there are no major portfolio issues and the cautious asset allocation suggests that ARCC can withstand a recession.
On an LTM basis, the payout ratio is only 90% due to the strong year-over-year rebound in net investment income. Additionally, management increased the dividend by 2.4% and covered it with net investment income.
Since management has a high level of confidence in the potential of their portfolio, otherwise they wouldn’t have increased the dividend, so can you.